Investment Conclusion: We reiterate our Buy rating and $85 price target on Focus Media. We recently hosted an investor call with CFO Daniel Wu who outlined key drivers for the company heading into 2007. Positive data points include favorable advertising trends, increased pricing leverage, strong demand in tier II markets, and encouraging developments in new business initiatives. We believe the company provides a targeted platform for advertisers to reach their respective demographics. With further deregulation in key industries in China, we believe this trend will drive spending for foreign companies and domestic state-owned enterprises that are forced into competition.
Key points from our call:
• Advertising Trends Very Favorable. Management sees favorable trends heading into 2007, indicated by the success of the recent CCTV auction. During the colorful annual event, domestic advertisers increased their budgets significantly for 2007. The company pointed out that deregulation is a main catalyst behind that as the company expects increased spending from banking and insurance sectors. We expect other key industries will also drive advertising spending due to WTO such as automobile (lower tariff) and telecom services. We believe this trend is very positive for Focus Media’s in-store and residential networks that have mostly domestic advertisers.
• Pricing Trends Positive As Well. Focus Media posted new rate card for 2007 recently. Management reaffirmed on the call that pricing is moving in the right direction, and expects to increase rates twice a year. For tier I markets, the company plans to raise the listed price by 8- 12%, in line with previous expectations. For tier II markets, the 15% increase was slightly above management’s anticipation, indicating strong demand in those areas. We also see robust price increases for segmented channels and especially outdoor networks, driven by luxury goods advertisers seeking a targeted platform.
• Suitable Platforms for Luxury Goods Advertisers. Management believes the LED outdoor networks are a natural fit for luxury goods since the screens are located in premier shopping districts. Although this segment is still relatively new, the company has seen a strong demand for ad slots, indicated by its 40% yoy increase in listed price. Advertisers are mostly brand names, such as high-end cosmetics, watches, apparel and automobiles. The company also thinks that residential buildings are a good platform as well, as it targets high-end condos with consumers that are image-conscious with significant purchasing power and disposable income. Another suitable platform would be Focus Media’s segmental channels. Daniel Wu pointed out that if an ad for luxury goods was placed in commercial networks, probably 99% of viewers cannot afford the product. Focus Media targets locations with likely buyers, including airport VIP lounges, Golf courses and country clubs, where more than 50% of viewers can likely afford a BMW. The key for the segmented strategy is to identify outdoor locations and deliver advertising to targeted groups of consumers.
• Commercial networks – an orderly expansion. Management believes the next wave of growth will come from the top 10-12 cities in China, where major brand advertisers are concentrating their marketing efforts. Larger tier II cities are similar size to smaller major cities. For example, Chengdu is more or less in line with Shenzhen, which is the fourth largest advertising market in China. These markets already achieved 70-80% capacity utilization.
o The goal for 2007 is to sell out all the slots in these markets, thus driving up price per slot. After that, the company plans to replicate the success and move into the next 10-12 markets, as major advertisers start moving into even smaller markets.
o Economics for tier II markets are attractive according to management. Though rates are lower, costs are lower due to less building coverage and lower rental fees. The company believes that tier II should eventually have similar profit margins (70%+ GM), if not higher than those of tier I markets.
o Competition in tier II markets appears minimal. The market is quite fragmented where small operators are strategic partners of Focus Media. The company plans to roll them up in the future. In the meantime, Focus Media buys commercial slots on a wholesale basis from small tier II operators.
• In-store Networks - Drive Occupancy Rate and Margins. Management feels that the company already has enough market share (~65%) to build a successful business. With that in mind, we believe the goal heading into 2007 is to drive penetration for the segment, which was 33% at Q3:06.
° Keep in mind that the in-store business takes more time to develop compared with commercial networks because it has a national reach. Compared with commercial networks, Focus Media can be much more flexible and choose to enter on a market-by- market basis.
° Looking at the revenue ramp-up, in-store networks has achieved similar success to that of commercial networks, reaching $7M quarterly revenues in a year and a half. However, in- store networks take longer to drive margin expansion given their nationwide capacity. The segment generated a GM of 36%, and management expects to achieve 55-60% by year- end 2007.
• Residential Networks - Starting the Tier II March. Management stated that the addressable market is quite large for the residential business, with ~150M urban consumers in china, most living in high rise condos. Focus Media has nearly 100% of coverage in major cities, and 30% of the country in total. The strategy is to move into secondary markets quickly to take advantage of market fragmentation. The company has already entered into five tier II markets. Management feels that advertising demand in smaller markets will be driven by local businesses such as restaurants, beauty parlors, hospitals and schools instead of major brands in large cities.
• Clarification on Lock-up Expiration. Management also clarified confusion related to the company’s lockup expiration, anticipating roughly 7.5M shares eligible for sale at the end of February 2007. For Target Media, it has roughly 5.3M shares, or 10% outstanding. For Framedia, it has roughly 2.2M shares, or 4% outstanding. We also note that Framedia may be entitled to additional 3.8M shares based on earn-out. Lastly, CEO Jason Jiang still owns 15% stake and is not subject to lock-up.
• Buy on Lock-up Related Weakness. We recommend investors buy shares of FMCN on weakness ahead of the of the lock-up expiration in February of 2007. Based on the two prior lock-ups, the stock gained 7% and 10%, respectively, 2 months after the announcement of the company’s secondary offerings. Keep in mind the upcoming expiration will be the last lock-up related to the company’s acquisitions of Framedia and Target Media, thus removing an overhang for the stock.
Focus Media Holding Limited is the largest outdoor advertising firm in China. It operates a network of flat-panel audiovisual television displays carrying advertisements. The network consists of commercial location network, in-store network, poster frame network, mobile handset advertising network and outdoor light emitting diode [LED] network. The flat-panel displays are typically installed in high-traffic areas, such as in commerical office buildings and in retainl chain stores. The company’s network covers about 20,000 commercial buildings in 91 major cities in China. Major clients include large corporations such as Toyota, General Motors, Nokia, Motorola, Bank of China, and China Mobile.
FMCN 1-yr chart:
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